News: Swaps Step inFor Treasurys

Not unlike the condition in mortgage passthroughs, there has been difficulty in valuing structured product off of the Treasury curve recently due to the conditions brought on through buyback plans.

Credit Suisse First Boston noted that on a Treasury option-adjusted spread basis, 10- and 20-year planned amortization class bonds widened 52 and 58 basis points during the first quarter, respectively, though have cheapened on an OAS basis.

"Market conditions are really crowning the swap market as the benchmark of valuation in the way that the Treasury market has traditionally been the valuation," said Michael Youngblood, managing director of real estate at Banc of America Securities. "It has become increasingly common in commercial mortgage-backed securities. It reflects the acquiescence by most traders and investors to use the swap market as our best gauge of generic spread activity."

Though perhaps setting the price on asset-backed securities since late January, the swap curve index has officially emerged a benchmark of choice for longer, fixed-rate tranches of asset-backed deals, having already been applied in several transactions over the last few weeks.

Further, increased use of swaps for hedging against asset-backeds could potentially move swap spreads out, though not significantly, market watchers say.

Benchmark issuers GMAC and Ford Motor Credit set the precedent by pricing the first two deals off the swap curve within two days of each other earlier this month.

"The GMAC and Ford transactions, I think, are perfect examples of the way the market is beginning to move," said Jeff Salmon, head of ABS research at Barclays Capital.

Salmon wasn't surprised the migration came when it did. In Ford's last $2.7 billion auto-backed deal, several Treasury-indexed tranches were pushed out because swap spreads moved out.

"Now an investor's first response is to say, Well what's going on, is there something wrong with the deal?' And the answer is no, it's just that swap spreads have widened," Salmon said. "The key point here is to put a sense of stability in the market, and the way to do that is by keeping the spreads flat or static. So at the end of the day, when people are watching the swap spreads move in or out, the margins will stay consistent."

As noted by Alex Roever, head of the ABS team at Banc One Capital Markets, bankers have been pricing short, money-market tranches off the Euro-dollar curve for two or more years now.

"In terms of pricing new deals, the swap curve seems to work very well, because it captures a lot of the volatility of spread products in general," Roever said.

So by way of swaps, what is really being priced is the change in the demand for asset-backeds versus other spread products, when considering the swap yield as a proxy for spread-product yield, Roever said.

Though GMAC and Ford were the first to officially do it, investors have been comparing asset-backed yields to swap curves on an informal basis for some time.

"Traders on the asset-backed desk and on other spread product desks have been showing out levels, and referencing them to swaps, because there's such a keen awareness of the relationship between the swap market and spread products," said Louis Nees, swap trader at Bear Stearns.

Also, though swaps have been increasingly used for hedging positions against asset-backeds, the advent of swaps as a benchmark may further increase the use of swaps for hedging, Nees said.

"If something is your benchmark, you tend to hedge with it, otherwise you tend to incur more basis risk," Nees said. "So probably in general what this does is it makes the next marginal player use swaps to hedge himself."

This activity will tend to make swaps more liquid, as players will be increasingly hedging and unhedging their positions.

Initially, if there is a substantial spurt of swap usage for hedging, there could be a slight widening of swap spreads, though this effect would eventually reach equilibrium, according to a swap industry source.

As for the search for a benchmark, most analysts will say that the quest to replace Treasurys originally came about after the liquidity crisis of the international markets in 1998. At that time, Treasury bonds, instead of moving in tandem with spread product, went the wrong direction, and players who were in short positions lost big.

In late January, following an announcement that the Federal Reserve was planning to curtail issuance and supply of long-term bonds, the debate for a replacement benchmark was refueled.

In February, market participants and analysts were looking at the indices of bonds issued by Freddie Mac and Fannie Mae, both government sponsored enterprises, as replacement benchmarks.

However, in March, a move by the Department of the Treasury, which in effect, set further distance between the GSEs and the federal government, subsequently widened yields on Fannie Mae's 10-year benchmark bond to its highest recorded level. This event effectively pushed the GSEs out of the running for a spread product benchmark, at least in the near term, sources say.

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